Most investors think that Fannie and Freddie are worthless as losses have continued to mount. But are they?

The US has continued to pump money into them. The latest tab totals $151 billion in preferred stock currently paying a 10% dividend that comes ahead of the common and the preferred stock owned by the public. Dividends have been suspended on the public preferred. These public preferred issues have a total market cap of about $800 million, but a stated value of about $30 billion. They are held by private investors, mostly banks. The US has also bought and guaranteed large amounts of Fannie and Freddie's debt. By conventional valuation both of these GSE's should have been liquidated long ago, with the public shareholders wiped out!

But a funny thing happened on the way to bankruptcy: the government thinks they are too big to fail. Currently, These GSE's guarantee almost all the conventional mortages that are being written, while FHA guarantees the smaller amount of risky mortgages that continue to be written.

Fannie and Freddie are back in the business of guaranteeing high down payment conventional loans to creditworthy borrowers, a business that continues to be very profitable. Were it not for their legacy costs and the high dividends the government receives on its preferred stock, Fannie and Freddie could do an IPO and perhaps raise enough capital to support a reduced role confined to their traditional, highly profitable business.

Will this happen? Maybe it will, if not soon, perhaps sometime in the not too distant future. Maybe it won't happen, and shareholders will lose the remaining 1%-2% or so of their former market cap. If that happens the common and preferred in the public's hands will be a total loss. But, if there is eventually a favorable outcome along the lines of the government's bailouts of AIG, Ally and the big banks, there will be something left for the stockholders, especially the holders of preferred stock, mostly small or regional banks that have been ignored in the effort to save the big banks. They had been told by regulators that Fannie and Freddie preferred was the only high yielding security they could own because it was so safe with AAA ratings.

If there is something left for stockholders, it is likely to be many times the current market cap for the preferred stock if the pattern of exchanging preferred for common that has taken place in unwinding the other bailouts holds. Therefore, there may be an asymetric risk/reward profile in owning the preferred.

Let's assume that there is a probability of some sort of a successful outcome. If we go by the pattern that has been set with the unwinding of other bailouts, that probability may be high, perhaps 90%. However, in view of the much worse shape of Fannie and Freddie than the other institutions, lets discount the probability of some sort of successful outcome to only 50%. Heads, you lose your investment. Tails, you win. But how much? A little? A lot?

Lets look at AIG. The common shareholders wound up with about 10 % of the equity. The government gave up its preferred priority and high dividends in exchange for common stock and chose not to exercise its warrants. If that pattern should hold in the event of a reorganization of Fannie and Freddie, the preferred shareholders might own 90% of the common, with perhaps 75% of the common in the hands of the government and 15% of the common in the hands of mostly banks that own the publically traded preferred. The government might put the remaining bad loans in runoff. Current common shareholders might retain 10% of the new common. If there is then an IPO to raise more capital, the former shareholders of the publicly traded preferred might eventually own less, perhaps 7/12% to 10% of the new common with the holders of the old common having a lesser amount, perhaps 6.7% to 5% of the new common.

How much might such a recapitalization be worth for a combined Fannie and Freddie with restrictions that was restricted to guarantees of solid, conforming mortgage loans with their bad loans behind them? Then, the new Fannie/Freddie wouldn't have to pay the crushing preferred dividends the US now receives. If the new Fannie/Freddie were worth $80 to $120 billion in a few years, the public preferred that would be exchanged for common might be worth 10 to 15 times its current market cap of about $800 million. However, the common with a current market cap of about $2.8 billion, might not fare so well in a recapitalization that is similar to the unwinding of other bailouts.

This is merely speculation. But, thinking through possibile outcomes may help prepare for an important event that may help clarify Fannie and Freddie's future. Under the terms of the financial bill passed last summer, the administration is supposed to present a plan for Fannie and Freddie's future by the end of January, 2011.

Is there a margin of safety in this speculative situation? Perhaps. Simply, wait a few days until the end of January, 2011 deadline. Then, there could be a margin of safety if the administration's plan is well received and favorable for recouping significant value for the publically traded preferred that's owned mostly by the banks. In the past, this preferred has often been overlooked by other investors because the common is much more liquid. We've made good money in the last two and a half years arbitraging the spread between the common and the relatively cheap preferred, and we continue to trade in and out of them. But, owning the preferred or common could be risky as the deadline for an announcement about their fate approaches by the end of this month. It's possible that the administration's plan might not follow the pattern of the other bailouts of leaving something on the table for current shareholders.

On the other hand, it's not out of the question that the plan might retain the full stated value of the public preferred issues, as was the case with Ally's recapitalization. If so, the banks might be made whole on their investment in the preferred, just as the holders of Fannie and Freddie's debt have been made whole. If so, the public preferred could eventually be worth their stated values that are about 40 times the current market prices.

Nevertheless, Fannie and Freddie's stockholders could fare worse than the stockholders of the private companies bailed out during the crisis. This would be a big political stink, especially as these GSE's have not been run entirely for the benefit of their shareholders during their conservatorship. Perhaps, the the plan the administration will announce soon will have important details about the future value of the common and preferred.

couple problems I see:- those FRE and FNM gov's pfds have10% coupon on them, so they will suck up any possible profit from the portfolio.- they will to run down their book somewhere down the road.- This implicit-gov-private mortgage model may not be continued in the future.

Having said that - I have a less 0.5% position on them. Their spreads are wide now given they are all in the pinkie land.

You have thought alot about this. A couple of questions and clarifications:

1) The preferreds you are discussing are FNMA series of 25 and 50 par value currently listed on the OTC market, comparable issues for FMCC?

2) If the gov't announces something with a positive outcome for the preferreds will they have a sudden pop eliminating some of the risk premium?

3) Could the preferreds be continued with no dividend or reduced dividend? This is probably in the relevant legislation but you may know it off hand.

Great questions.

1). Generally, yes. However, one of the issues has a huge stated value per share. This one may be owned 100% by banks, and it never trades. Another issue is scheduled for mandatory conversion to common in a few months, and shouldn't be held if one thinks as we do that the common is very overpriced in relation to the preferred.

2). Not necessarily. The reason the common trades so high in relation to the preferreds is a liquidity premium. In the past, when there has been a favorable developmnt for stockholders, it is generally the common that jumps up in price more than the preferreds. This makes it difficult to profit immediately by shorting the common and buying the preferred. It may not be possible to short the common now after it moved to the pink sheets a few months ago.

As interest in Fannie and Freddie has waned over the last two years, the liquidity premium has become generally less but still very high. The spreads between the bid and ask have been very high for most preferred issues, except the FNMA T and S series. This has presented an opportunity for retail customers to profit because potential market makers are scared to hold these issues. Interestingly, S and T are traded with greater volume and generally have a significant liquidity premium compared to the other preferreds. However, any favorable development that especially benefits the preferreds should eventually be reflected in the prices relative to the common as Mr. Market sometimes does put on his thinking cap.

3). I think the most likely outcome that might benefit the preferred holders would be a preferred to common exchange as happened with some banks and AIG. If so, it might take a few years before dividends might be resumed on the common. If this happens, These GSE's won't be burdened with having to pay $15 billion in annual dividends to the government. Without this burden, Fannie and Freddie may be on the verge of becoming cash flow positive if current trends continue. Please keep in mind the very real possibility that stockholders, including the preferred holders, could be wiped out.

This will likely work out but its too dicey for me (and I own a few over-levereaged doggy investments). The Republicans (perhaps rightfully so on this one) are quite anxious to end the support of the GSEs and put them into run off. Now may not be the right time due to the structure of the market but eventually I think there will be a fight over it.

Every other distressed banking entity has been a money maker for those that went in after the carnage had done its damage, but this one is a hairy one. I still dont see or understand why the government is allowing private investors to profit from these entities prior to the public recouping 100% of its support but they are. I will be watching.

This will likely work out but its too dicey for me (and I own a few over-levereaged doggy investments). The Republicans (perhaps rightfully so on this one) are quite anxious to end the support of the GSEs and put them into run off. Now may not be the right time due to the structure of the market but eventually I think there will be a fight over it.

Every other distressed banking entity has been a money maker for those that went in after the carnage had done its damage, but this one is a hairy one. I still dont see or understand why the government is allowing private investors to profit from these entities prior to the public recouping 100% of its support but they are. I will be watching.

You're right. It's hairy to jump in before a plan is presented and the reception to the plan is evaluated. However, the Republicans on the House Banking Committee have backtracked and no longer endorse the Republican position of last summer. One of them used to be a banker and real estate developer. Who knows, he may be buddies with some of the bankers that would like to see the value of the Fannie and Freddie preferred that their banks hold made good! The chairman of that committee has cautioned that it would be unwise to withdraw the government's support anytime soon. Times are 'a changing. Who knows what will happen? Time will tell.

Administration's plan delayed till after budget is presented week of Feb 13, 2011. This should allow the stock another three weeks to run up before D day.

The preferreds have doubled since December and the common is now hopping to catch up. FNMA is up 23% and FMCC is up 28% today and up about 60% in the last week.

Up another 24% today for both FNMA and FMCC. This is almost a double from their January 19, 2011 prices. The common has now almost caught up with the price increases for the more liquid preferred issues.

This is in our "no brainer" pile because we have become so familiar trading it for almost 2 1/2 years. This is what it always does in an up market when there is some credible catalyst that may remove uncertainty about their future.

Fannie and Freddie up 31% and 35% for the day. Not nearly as much for the preferreds. This price action is typical with these volatile issues. Last summer, short sellers piled on and drove the price down to half tha previous close after the administration announced that they were delaying the announcement of their plan for F & F.

The pricing on the less liquid preferreds is far from efficient. We have reduced our net long position a little as the prices have risen. However, if the past is a good guide, prices should continue to rise until D Day draws nigh.